Canada's national office vacancy rate is at an all-time high, an indicator of the continued softening demand for office space as work patterns and real estate needs shift.

The overall vacancy rate for the country reached 17.7% in the first quarter, CBRE said in a report Wednesday. Ten of the last 12 quarters produced negative absorption as more space was put on the market than was leased to tenants.

"Office vacancy continued to rise in Canada's major markets in the first quarter as the sector undergoes a once-in-a-generation evolution, with tenants seeking to adjust to hybrid work and office landlords striving to maintain their appeal," said CBRE in the report. "The result is a sector in flux and greater separation forming between uninspired older offices and well-amenitized modern spaces."

In the country's largest office market, CBRE said the downtown Toronto office vacancy rate hit 15.3% in the first quarter, its highest rate since 1995. Vancouver's downtown office vacancy rate rose to 10.4%, the highest since 2004. And Ottawa at 13.2% and Montreal at 16.5% also recorded their all-time highest downtown office vacancy rates.

Calgary saw a 10-basis point drop in its overall vacancy rate, in part because of office conversion programs making inroads, CBRE said. Alberta's largest city has earmarked funding to make the cost of converting office buildings into housing more palatable.

"It's worth exploring every avenue possible for housing," said Doug Porter, chief economist with Bank of Montreal, in an interview with CoStar News. "Demand for housing is going to be insatiable. Otherwise, we will have this bizarre situation of a glut of office real estate and a shortage of residential real estate."

Higher vacancies across the country have led to fewer office projects. CBRE said there is only 11.2 million square feet in the development pipeline across the country, the lowest level since 2017 and equal to 2.3% of Canada's total office inventory.

"I dare say it is probably going to be some time before there is a significant office built," said Porter. "We went through a decade of almost no office building [in Toronto]. I'm not saying we are going to repeat that nationally, but you have to wonder."

Paul Morassutti, chairman of CBRE Canada, said the office market is in the midst of an evolution similar to what the retail sector has experienced over the past decade.

"Demand for cheap commodity space has evaporated and been replaced with the desire for spaces that act as conductors for business productivity and development. There is a greater focus on higher-quality and highly amenitized office assets as companies learn that remote and in real life are not binary choices, but in fact, each reinforces the other," said Morassutti in a statement.

CoStar data also continues to show the market evolving, but chief economist and head of market analytics in Canada, Carl Gomez, offered some caution.

"We believe that structural changes related to the way employees work alongside the cyclical impact of a looming recession is likely to have a detrimental impact on the office market and values over the near and medium term," he said. "But we can't paint things out with the same brush. CoStar data shows that the impacts are far more nuanced and are affecting the office buildings differently, both in terms of relative location and quality type."

Rising interest rates are also starting to affect some owners, namely office real estate investment trusts, Morningstar said in a March 31 report.

"Among the stocks hit hardest in the sector have been office REITs, which rent out office spaces and amenities to businesses. On average, office REITs saw their stock valuations drop about 24%" during March, making it "the worst-performing industry in the sector," Morningstar said.

"The recent bank run emphasized two risks to the real estate sector: tenant risk and financial system stability. These risks place further pressure on REITs' funds from operations and their ability to roll over looming debt maturities," Morningstar said.

Morningstar warned that during times when fears over financial instability arise, capital markets — those in the business of lending money — tend to become significantly less risk-tolerant.

"That often leads to a credit crunch, where it becomes difficult for companies and businesses to find lenders to help them remain liquid," Morningstar said.